Regulating Short Selling: The European Framework(s) and the Regulatory Arbitrages

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Regulating Short Selling The European
Framework(s) and the Regulatory Arbitrages
Giampaolo Gabbi and Paola Giovinazzo
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Reading Questions

1. Which is the difference between the regulatory
   and the fundamental view on short selling?
2. Did all the European countries introduce
   prohibitions for short sellers after the crisis?
3. Did European Market Authorities introduce a
   regulation on short selling after the financial
   crisis in the same time and for the same
   duration?
4. Is the European regulation on short selling based
   upon an harmonized framework?
5. Which is the purpose of the short selling
   regulation in the United Kingdom?
6. Why Germany introduced a restriction on short
   selling for bonds in January 2010?
7. Which are the main features of the French
   regulation on short selling?
8. Why the Italian Authority decided to use moral
   suasion before restricting short selling
   activities?
9. How short selling regulation has been calibrated
   in European countries?
10. Which is the impact of heterogeneous regulations
    in Europe?

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1. The regulatory view vs. the fundamental view

• According to the regulatory view, short selling
  amplifies price collapse when uncertainty and
  information asymmetries converge towards a
  negative scenario.
• This is the rationale by which, financial market
  authorities introduced different types of bans in
  order to avoid speculative forces destabilizing
  financial markets.
• On the other side, according to the fundamental
  view short sellers use information to influence
  the convergence of asset market prices to their
  fair values.

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2. European countries decisions after the crisis

• A majority of European countries introduced
  restrictions on short selling activities during
  the months of September and October 2008.
• Their range and number of restricted assets were
  partly diverse with different durations.
• The are some countries that did not introduce any
  type of restriction on short selling.
• These countries are the Czech Republic, Finland,
  Hungary, Poland, Slovenia and Sweden

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3. When European Authorities introduce their
regulation

• European Countries who decided to introduce short
  selling restrictions, implemented the ban after
  the Lehman Brothers collapse
• The first countries to introduce restrictions, on
  19th September 2008 (that is 4 days after the
  bankruptcy), were Ireland, Luxembourg,
  Switzerland and the UK.
• The last country to introduce restrictions was
  Belgium, on 26th October 2008
• On average, restrictions delayed 13 days after
  the Lehman collapse.
• This heterogeneity affected the European market
  equality and the opportunistic behaviour of some
  financial players

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4. The European regulation framework on short
selling

• The prohibition of short selling of all stocks
  listed in the market arises some indirect costs
  pricing efficiency, liquidity shortage, foregone
  profits and consequent trading reduction.
• Therefore, regulators when introduce such bans
  need to avoid any type of regulatory asymmetry
  among countries and financial players.
• This risk is higher when regulations are managed
  by agencies with heterogeneous organizations,
  missions, and supervisory tools. This is what
  still happens in Europe, where besides a common
  Financial Markets Directive (aka Markets in
  Financial Instruments Directive (MiFID), there is
  at least one supervisory authority for each
  single country.
• This could be considered a critical point of the
  European financial markets, for the existence of
  many agencies and frameworks where short selling
  is regulated and supervised

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5. The purpose of the short selling regulation in
the United Kingdom

• In the UK, the Financial Services Authority (FSA)
  introduced new provisions to the previous Code of
  Market Conduct to forbid the formation or the
  increase of net short positions for both naked
  and covered short sales in publicly quoted
  financial stocks. The main purpose is stated as
  follows
• to protect the fundamental integrity and
  quality of markets and to guard against further
  instability in the financial sector
• Financial Services Authority (2008) FSA
  statement on short positions in financial
  stocks.

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6. The rationale of restriction on bonds in
Germany

• On January 18, 2010 the ban for naked short
  selling on financial stocks was reintroduced for
  sovereign bonds issued by European countries and
  for credit default swaps brokers.
• The purpose was to support bond prices during the
  Euro crisis and the speculative pressure against
  Greece.
• Since this regulation was that it applied only
  for the domestic market, all banks outside
  Germany could continue taking short positions on
  sovereign bonds, however, most of the large
  banks, decided to manage short selling operations
  from their foreign offices.

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7. The main features of the French regulation

• The French Authority (AMF) wanted to provide as
  much consistency as possible between the Paris
  marketplace and major foreign financial centres,
  in particular those that are home to markets
  operated by Euronext.
• Therefore, AMF banned naked short selling and
  requested that financial institutions abstain
  from securities lending transactions in financial
  stocks.
• Short positions generated through the use of
  derivatives, such as futures were also banned.

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8. The effectiveness of moral suasion in short
selling

• The Italian Market Authority (CONSOB) after the
  Lehman collapse decided to apply the moral
  suasion as a means of intervention to reduce the
  activity of short selling.
• The purpose was to reduce speculative activities
  against financial stocks during the crisis
• The impact was considered inadequate for the
  magnitude of the crisis and, three days later,
  CONSOB decided to ban naked short selling.

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9. The approaches to calibrate short selling
regulation in Europe

• The direct approach defines objectively
  restrictions to short selling by assets and
  market players, taking into consideration covered
  and naked short selling investors activity and
  specialization
• The disclosure approach requires more information
  on trading activity from financial firms in order
  to monitor short selling volumes and increase the
  disclosure. The information can be provided to
  regulators or directly to the market
• The mixed approach combines the previous two
  approaches, in order to minimize the negative
  short selling impact and supervise more
  effectively financial speculation.
• In Europe 4 countries applied the direct approach
  and 10 countries the mixed approach. Only Italy
  initially choose the disclosure approach, almost
  immediately suspended.

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10. The impact of heterogeneous regulations in
Europe

• While the actual effects of this temporary
  action will not be fully understood for many more
  months, if not years, knowing what we know now, I
  believe on balance the Commission would not do it
  again. The costs (of the short selling ban on
  financials) appear to outweigh the benefits
• Christopher Cox, Chairman of the SEC
• Our study shows that European countries suffered
  of the disadvantage of a heterogeneous short
  selling regulation system which induced
  opportunistic behaviours.
• The implication is that imperfect harmonization
  among regulators reduces the expected response of
  market players and increases the risk of
  competitive distortions, creating an advantage
  for a few players.

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Conclusion

• This analysis provided insight into
• The regulatory framework of short sales in
  European countries, particularly Germany, France,
  Italy and the UK
• The rationales of short sales restrictions in
  Europe
• The impact of the short sale prohibition
  differences in European countries
• The need for a homogeneous and coordinated set of
  rules in countries where many financial players
  can freely settle and operate with a license
  given by the home country regulator